Commodities are physical goods attributable to resources that are tradeable and supplied without substantial differentiation by the general public. This includes goods such as grains, gold, beef, oil and natural gas. More recently, this definition has expanded to include financial products such as foreign currencies or technological products such as bandwidth. These economic goods are essential to the world economy because they are essential to the production of other goods and services.

So what does investing in commodities mean? How do buyers and sellers communicate, create contracts and execute orders? Today, all of these exchanges occur within a Commodity Market where exchanges regulate and standardize the trading practices. Examples of such exchanges include The New York Mercantile Exchange (NYMEX), which trades oil, gold and silver, among other precious metals. On the other hand, the Chicago Mercantile Exchange (CME) trades food-related commodities such as milk, butter, cattle and even lean hogs.

Within these exchanges, commodities generally trade in two types of markets: [Spot Markets and Derivative Markets] (https://www.forbes.com/advisor/investing/commodities-trading/). Spot Markets can be understood as “physical markets” where buyers and sellers create a contract where goods are delivered immediately. Due to the intent to deliver immediately, the prices in spot markets reflect current supply and demand conditions.

Derivative Markets are fundamentally different because buyers and sellers do not create a contract for immediate delivery. Instead, the contracts set terms of price and delivery date today for physical delivery of the goods at a pre-decided date in the future.

A common type of derivative is a futures contract, which is traded on an exchange and terms are standardized across the market. In order to make them easier to trade on an exchange, these contracts are not customizable. If an entity seeks a customizable contract, they create another form of a derivative contract — a forward. The terms for this contract are set directly between two parties.

To contextualize this information, let's look at an example of a buyer wanting to buy a barrel of oil. If the buyer wishes to have immediate delivery of this barrel, they will trade in a spot market via the NYMEX. Alternatively, if the buyer wishes to have delivery of this barrel a month in the future, assuming this is a standardized contract, they would engage in the derivative markets via the NYMEX. Lastly, if our buyer wishes to create a custom contract for future delivery, one with terms that cannot be found on the NYMEX, they can create a forward contract directly with a supplier.

Commodities tend to be the most volatile asset class and several studies have found that [global macroeconomic shocks] (https://blogs.worldbank.org/developmenttalk/commodity-price-cycles-causes-and-consequences) are the main reason for this volatility. Global recessions have been known to disrupt supply chains and dampen demand which lower commodity prices. In the recent past, we saw the COVID-19 pandemic [depress the outlook for the demand for crude oil] (https://www.bbc.com/news/business-52350082) and forced U.S. oil prices to go negative for the first time on record. This underlines the importance of expectations in determining prices. Since derivative markets reflect expectations, geopolitical events and changes in government policies can also influence the outlooks of these expectations.

The uncertainty in prices and the volatility of the asset class make commodities attractive to stakeholders who trade in the commodities market. With differing strategies, the commodities market has a place for consumers, producers, speculators and investors.

The exchanges enable producers and consumers to access each other in a centralized and liquid marketplace to create spot or futures contracts. This ensures that companies can secure inputs of production efficiently in the present and the future. Alternatively, we may see speculators buy futures contracts for commodities with expectations of capturing profit by selling short or a price rise. Lastly, investors can use these markets as insurance against stock market volatility as these markets are historically known to move in opposite directions.

The various uses of these markets illustrate how essential commodity markets are to the function of the global economy. Despite this function, these markets are less commonly known than the equity markets or money markets. This is simply because these markets are not as accessible as the stock market to the average consumer – trading in commodities is complex, they do not generate passive income and these markets are often easily manipulated. However, an average retail investor can still use exchange-traded funds to gain exposure to these markets.

The commodity markets have come into increased prominence due to the flurry of global crises in the recent past leading to wild fluctuations in the prices of oil, metals and wheat. These fluctuations have highlighted the essentiality of these markets by displaying how they facilitate demand and supply to reach equilibrium, ensuring that production can continue globally.